When planning for retirement income, many people choose to rely partly on an annuity, which is a financial product that provides you with future, regular payments in exchange for a premium paid up front. If you've chosen this option, understanding how to find the present value of an annuity is an important part of making savvy decisions about your money.
An annuity's present value is based on the time value of money — i.e., $1,000 you receive today is worth more than $1,000 you'd receive in five years. This is because you can invest $1,000 today and see it grow over time. However, knowing that an investment can grow over time isn't enough to help you determine your annuity's present value. To do that, you have to do a little calculating.
Defining the Present Value of an Annuity
Because your annuity contract promises you future payments, you'll want to understand how much those payments would be worth over time if you received them right now. This is what's known as the present value of your annuity.
This calculation is particularly important if you're able to choose between receiving benefits as a lump sum or as equal payments over time. You need to know if your lump sum payment would be greater than the present value of your future annuitized payments or if you would get more money if you received regular payments over time.
How to Find the Present Value of an Annuity: The Present Value Formula
The formula that will help you determine the present value of your annuity is as follows:
Present value = PMT x ((1 − (1 / (1 + r)n )) / r)
To make this calculation, you'll need to know the following factors:
- PMT = Dollar amount of each annuity payment
- r = Interest rate (also known as the discount rate)
- n = Number of periods (or years) in which you can expect payments
If this is beyond your back-of-the-envelope mathematics skills, don't worry — you're not alone. There are a number of online calculators that will do the math for you.
For example, let's say your annuity promises $30,000 per year (PMT) with an interest rate of 5% (r) for 20 years (n), or you can opt to take a $360,000 lump sum right now. To make this decision, you would need to know if your annuity's present value is greater or lesser than the offered lump sum. Here's how you would calculate the present value:
Present value = $30,000 x ((1 − (1 / (1 + .05)20 )) / .05)
Your calculations will show that the present value of your annuity is $373,866.31, which is clearly higher than the lump sum amount of $360,000. In this case, as long as you don't need an immediate injection of cash, you'd be better off taking the annuity payments that you'll receive over time.
Factors That Can Complicate Present Value Calculations
Calculating the present value of your annuity is a relatively simple process if you have a fixed-rate annuity that's paid over a defined term. However, alternate annuity products can make the present value calculations more complex.
For instance, if you have a variable rate annuity, you're not guaranteed a specific interest rate. Instead, your rate is determined by the specific assets your annuity is invested in. This means you get to take advantage of market upswings, but you're also vulnerable to losses. It also makes the calculation of your present value tougher, because you'll have to guess about the interest rate.
Similarly, some annuities have indefinite payment schedules. These are also known as lifetime annuities, and they're set up so you'll receive payments until your death. They also present a complication to the present value calculation: Because you'll be guessing about how long you'll be able to expect payments, it's much harder to calculate a useful present value.
Making Smart Annuity Decisions
Knowing how to find the present value of your annuity can help you feel more confident when you make decisions about your annuity income. Understanding the present value formula and why it matters will help you make the best choices for your unique financial needs and retirement goals.
This material provides general information about the described insurance product(s) for educational purposes only. This is not intended as investment advice or to recommend the insurance product(s). The Center for a Secure Retirement does not provide legal or tax advice. Each individual should seek specific advice from their own tax or legal advisors.